Investing in a ground lease is a great investment opportunity for investors. It can be a superior way of generating revenue for those who want to deploy capital in real estate investment. The leased property can be bare lands without any constructions or developments also. With bare land, the property owner enters into a ground lease with the tenants.
Since the real estate economy is normalizing, investing in ground lease financing can be a viable financing technique for developers. In this situation, the landlord effectively owns a bond that implies an attractive interest rate. Hence, a project with a ground lease can be an excellent investment if it’s structured accurately.
In this blog, Lilypads is going to elaborate on the details of investing in a ground lease.
What is Ground Lease?
A ground lease or land lease is an agreement in which a property owner leases their land to tenants. Ground leases are generally long-term leases that allow the tenants to build construction or significant improvements to the leased property.
The lease term of ground leases generally lasts between 50 to 99 years. During this phase, the investor can use the leased property on their own or also can sublease it to other tenants.
In this ground lease, the tenants are responsible for paying the rent regularly (usually monthly). These leases are quite similar to triple net leases. Hence, in this lease, the tenants are accountable for paying property taxes, insurance, and other expenses throughout the lease term.
Furthermore, all the improvements and constructions made on the leased ground will revert to the landlord once the lease expires.
Types of Ground Leases
Based on the kind of financial distress situation within the lease term, ground leases are categorized into two major types:
1. Subordinated ground lease:
In a subordinated ground lease the landowner gets a lower priority on claims on the land while financing the tenants. Here the owner allows the mortgage of the land to the lender. With this lease type, the owner is allowed to seize your property deed in case of default on the loan. In the subordinated ground lease the landowner may negotiate higher rents due to the adhered risk of tenant defaults.
For example, if you sign a ground lease for a piece of land and then take a loan of $100,000 for constructing a hotel on it. But while remaining under the subordinated lease if you default on the loan, the owner overrides the property with the land. Thus, it is advantageous for the landowner since the value of the land increases with the construction.
2. Unsubordinated ground lease:
In an unsubordinated ground lease, the landowner gets the top priority in claiming the land leasing over any other lenders. In this lease, the lenders to the tenants can’t take the retaining ownership in case of any defaults occur by the tenants. Furthermore, the rents charged for these types of leases are comparatively lesser. And it’s quite difficult to get financing for these kinds of leases.
Ground lease pros and cons
Investing in a ground lease has both advantages and disadvantages for the tenants as well as for the landowners.
Benefits for the tenant
- Ground lease helps the tenants to own the parcel of land. As a result, they don’t require investing a huge amount of money in purchasing the property.
- With this option, they get a scope of investing their capital for the construction purpose or other expenses.
- For land leasing, the tenants don’t require any down payments whereas purchasing the land requires a down payment.
- Ground leases protect the tenants from market fluctuation as well as from inflation. Due to market fluctuations, the property value often changes, and tenants are shielded from those changeable.
- The rent payments by the tenants are excluded from state and federal income taxes. Hence, the ground lease decreases the overall tax burden for the tenants.
Benefits for the landlords
- The first and foremost benefit for the landlords is that the ground lease ensures a steady stream of income. In-ground lease the landowner is secured with long-term tenants and with a future appreciation of the property.
- Through this ground lease, landlords can increase the property value if they are unable to do it themselves.
- This lease contains a certain clause in the agreement which ensures the rise of rents and eviction rights. Thus, this clause provides security to the landlords during any case of default on rents.
- A ground lease is a tax saving for the landlords. In some cases, involving municipal lands, landowners won’t have to pay property taxes.
- Due to the rental income, the landowners have to pay certain taxes but still, there are tax exemptions.
- As per the agreement clauses landowners retain some controls over the property. Hence, the landowners can alter or deny any changes taking place on the property if they don’t want it.
- For tenants, the cost of ground leases may exceed the cost of purchasing a property in the long run.
- In addition to making any constructions or changes, tenants may need approval from the landlords which can cause delay. Furthermore, these restrictions can reduce the flexibility of the tenants.
- Thus, sometimes the rents, taxes, improvements, approval from the landlords can be exorbitant for the tenants.
- Sometimes, ground leases come with some tax implications for the landlords which may outweigh the benefits of tax savings.
- Also, if the lease payments are not adjusted for inflation and considered as fixed then it may increase the tax burden.
- If the landlords don’t include proper provisions or clauses regarding the changes with the tenants then they lose control. Hence, the tenants may not inform the landlords regarding the changes taking place. Thus, both parties must double-check the lease before signing it.
Examples of real-world ground lease situation
In the Las Vegas, Nevada area the state level and country-level officials made numerous lands available for ground lease. And they have leased those properties to private investors.
The American Tower (NYSE: AMT) is a good example of ground leases. They have ground leased on nearly two-thirds of the USA towers. Moreover, they are continuously extending their lease terms and also purchasing the lands whenever possible to terminate the lease.
Furthermore, McDonald’s, Starbucks, and Dunkin Donuts are all hitting the market while binding by a ground lease.
Risks of investing in a ground lease
Along with several benefits, ground leases do have some important risk factors which should not be overlooked.
When a real estate agent goes for a ground lease they require financing for construction purposes. But, the construction-related with a ground lease is complicated. As here the tenants don’t own the property they can’t grant a lien against it. And thus for taking the loan the lender will ask for a subordination agreement from the landowner.
In this agreement, landlords belong to the top priority in the hierarchy of claims if any case of default. Therefore, these subordination clauses grant some risks to the landowners also. In worst cases, if the tenants default on the loan then the lender will take back the property while selling it. While selling a home if the sale proceeds concede the loan amount then the landowner may also lose the property.
There is another risk factor when a tenant defaults which means the tenants won’t make their lease payments. While making the change or any new construction, the landowner must understand the developer’s plan thoroughly. Thus, with a complete understanding, they can assess the potential default risks.
Usually, the term period lasts for 50 to 99 years so both parties should have a complete idea of what happens at the end. And this mistake must be avoided by paying a bit of attention while preparing the agreements because by adding a reversionary clause, this risk can be mitigated. This clause means that the ownership of the improvement reverts to the landlord upon the expiration of the lease.
A ground lease can be a beneficial arrangement for both landowners and tenants. These kinds of properties are usually found in dense and urban areas. These are beneficial for tenants because they can access those properties located at that prime location without purchasing those properties. Ground leases also come with certain risks, thus due diligence is crucial. Therefore, with a good landowner and the right tenant, the ground lease can be a mutually-beneficial partnership.